in International Transfer Pricing

1. Western India Regional Council Sub Regional Conference, Baroda June-2013 in International Transfer Pricing CA T. P. Ostwal

2. A Snap Shot • International overview • Global Transfer Pricing Regimes • Transfer Pricing – A Global Outlook [UN & OECD] • Future of Transfer Pricing in Developing Countries • Transfer Pricing – Recent Trends in India • A Bird’s Eye View • Existing backdrop • Concern on Dispute Resolution Process • Indian Transfer Pricing – Emerging Areas of Controversies • Fundamental Issues • Specific Issues

3. Global Transfer Pricing Regimes • By the end of 2011 there were around 100 countries with some form of specific transfer pricing legislation as shown by the red shading in the diagram below

4. Global Transfer Pricing Regimes (contd…)

5. International Transfer Pricing A Global Outlook-un -oecd

6. United Nation’s Transfer Pricing Manual Country Practices – China and India’s views • Legal contracts asserting IP is held offshore will be disregarded • If it is found that the developing country subsidiary has engaged in activities that put it in control and create intangibles • Routine cost-plus returns will no longer be acceptable • for those contract R&D companies that are found to exert control or to enjoy a high-tech status • Limited risk distributors spending an excessive amount on AMP • will be expected to enjoy a share of the excess profits related to the local intangibles they are creating • Location rents • should be booked in the developing country under certain circumstances rather than being booked in either the tax favoured jurisdiction or the home country • Companies engaged in toll manufacturing • will need to add back the cost of the consigned materials into their cost base

7. United Nation’s Transfer Pricing Manual Country Practices – China and India’s views • Comparables should be viewed with caution given the paucity of information in developing countries. • MNEs that operate multiple entities, each with a single function, may not be able to claim that each entity is entitled to only a routine return • A holistic approach would be more appropriate. • Where a significant percentage of the global employees or assets are actually in developing country • A formulary approach may be the best method

8. Recent Developments - OECD • Proposed Action Plan/ Recent Updates • Improvements or clarifications to the transfer pricing rules • Rules relating to intra-group financing (e.g. interest deductibility, withholding taxes, etc) • Release of Draft Handbook on Transfer Pricing Risk Assessment by OECD's Global Forum on Transfer Pricing • Release of discussion draft on the Transfer Pricing Aspects of Intangibles • Updated solutions to the ‘jurisdiction to tax’ issues • More effective anti-avoidance measures

9. Recent Developments - OECD • Safe Harbour Rules - OECD approves the revision of Section on safe harbours in the Transfer Pricing Guidelines • On 16 May 2013, the OECD Council approved the revision of Section E on safe harbours in Chapter IV of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“TPG”). • Revised guidance advises countries to weigh benefit & concerns regarding safe harbour. • New guidance on safe harbours provides opportunities for countries to relieve some compliance burdens and to provide greater certainty for cases involving smaller taxpayers or less complex transactions. With that, it provides a basis for countries, especially developing countries, to design a transfer pricing compliance environment that makes optimal use of the limited resources available. • It further recommends use of bilaterally or multilaterally negotiated safe harbours for avoiding double taxation and double non taxation. It also provides a Sample MOU for bilateral safe harbours.

10. Future of Transfer Pricing in Developing Countries • The economic significance of the OECD is in rapid decline. • In 2000, OECD nations controlled 60% of gross world product. • Now it is at 50% and is expected to drop to about 40% in 2030. • Power and influence will need to be shared between developed and developing countries • With new players such as Brazil, Russia, India, China, and South Africa (BRICS), and the UN entering the fray, • India and China see themselves as "exceptional countries" and will want a say in writing the rules, whether it is greenhouse gases, transfer pricing, or intellectual property, and that is the way it will be. • Confidence levels among Indian and Chinese tax authorities are growing • It is clear that these developing countries will not allow themselves to be pushed around much longer. • Over 70% of the global transfer pricing litigation worldwide is in India a sign of that country's independent thinking.

11. Future of Transfer Pricing in Developing Countries • The big question is whether India and China will pass new regulations to incorporate the positions expressed in the UN manual. • If so, the nature of global transfer pricing will shift. • Location rents and local intangibles will become part of the analysis. • Finally, every global tax director of an MNE will need to figure out a new strategy • Because the principal structure used to provide developing countries a routine profit will get terminated

12. Transfer Pricing RECENT TRENDS IN INDIA

13. Indian Transfer Pricing A Bird’s Eye View

14. Indian Transfer Pricing A Bird’s Eye View (contd…) 70,000 44,536 23.238 10,907 6,491 6,138 1,612

15. Indian Transfer Pricing – Existing Backdrop • Transfer Pricing is the focus area for the Revenue Authorities • Legislative changes to plug potential loopholes • Increasingly aggressive positions adopted by the revenue • Augmented staffing and training of officers • Widened Scope & intrusive Approach of Transfer Pricing Assessments • Request for higher level of documentation • Legal back-up with greater investigation powers for revenue officials • Newer areas of challenge • Cross-border Financing arrangements, Intangibles, Intra-group Services, Investments in group entities and Share Valuation • Growing cross-country collaboration • Several exchange of information treaties effected • Extensive interaction with OECD officials

16. Indian Transfer Pricing – Existing Backdrop

17. Indian Transfer Pricing Concerns on Dispute Resolution process • Conventional Approach of Dispute Resolution - Tiers of Appellate Authorities [DRP/CIT(A)ITATHCSC] • Time consuming and several tiers of appellate authorities • Appeal by tax authorities in case of favorable resolution at lower levels • Factual nature of issues results in matter being remanded back • Uncertainty on eventual outcome and impact on financial statements • Risk of economic double taxation, if matter is resolved against the taxpayer • Measures to Handle Dispute Resolution – Discouraging experiences with DRP • Independence - Structural issues in constitution of Panel • Achievement- A “fast track” to next level of litigation? • Policy Moderation - Empowering tax authorities to appeal against order pursuant to DRP directions – Will there be any change in approach of DRP? • Modern Approach – International • Mutual Agreement Procedure (‘MAP’) - Emerged a viable alternative in recent times • Advance Pricing Arrangements – Will it result into an approach to bring certainty?

18. Indian Transfer Pricing Revised Reporting Requirements [Rule 10E] • Changes in Form 3CEB (Transfer Pricing Audit Report)

19. Indian Transfer Pricing Emerging Areas of Controversies

20. Significant issues on Transfer Pricing Principles • Fundamental issues • Deemed International transactions – A Reasonable Approach? • Tested Party – The right questions? • Location savings • Transfer Pricing Adjustment – Whether restricted to the overall group profits or total revenue from the transaction ? • Specific Issues • Intra-Group Financing Transactions – Guarantee/Loans etc. • Marketing intangibles (AMP) – Focus on fundamentals? • Contract Research & Development –Step towards Profit splits Approach!

21. Emerging Areas of Controversies FUNDAMENTAL ISSUES

22. Emerging Areas of Controversies Deemed International Transactions

23. A transaction entered into by an enterprise with a person other than an associated enterprise shall be deemed to be an international transaction if: There exists a prior agreement in relation to the relevant transaction between such other person and the associated enterprise The terms of the relevant transaction are determined in substance between such other person and the associated enterprise OR DEEMED INTERNATIONAL TRANSACTION Reasonable Approach? Deemed International Transactions • Section 92B(2) of the Act states that a transaction entered into with a person other than AE shall is deemed to be a transaction between two AEs, if there exists a prior agreement in relation to the relevant transaction between such other person and the AE or the terms of relevant transaction are determined in substance between such other person and the AE.

24. DEEMED INTERNATIONAL TRANSACTION Reasonable Approach? • Kodak India Private Limited [ITA No. 7349/Mum/2012] • The Tribunal discussed the provisions of section 92(1), section 92A(1) and section 92B(1), and the inter-linkage between them, to establish that they all relate to an international transaction between AEs, where both the AEs are non-residents or at least one of them is. • Further, the Tribunal also concluded that section 92B(2) cannot be read independent of section 92B(1), and thus section 92B(2) cannot apply to transactions between domestic entities. • A similar judicial precedent was laid down in the Tribunal ruling in the case of Swarnandhra IJMII Integrated Township Development Co. Pvt. Ltd. v. DCIT [ITA No. 2072/Hyd/2011] • Stratex Networks (India) Private Limited [353/2011Delhi High Court] • Indian Co. had agreements with local clients to install and maintain equipment supplied by its overseas associated enterprises. • The High Court upheld the Tribunal’s ruling that the installation and maintenance services were not deemed international transactions u/s 92B(2) because none of the conditions stipulated u/s 92B(2) existed.

25. DEEMED INTERNATIONAL TRANSACTION Reasonable Approach? • TypicalFacts – Outbound Investment • Indian parent company infuses share capital in the Foreign subsidiary (at premium or at face value per share in case of negative networth of subsidiary) • The Revenue takes a position that the shares have been issued to the Indian Company at an overvalued price/more than the fair market value of the shares; • The difference between the actual issue price and the ALP computed by the department is characterized as: • Deemed Loan by the Indian Parent - treated as TP adjustment • Notional Interest on deemed loan- treated as TP adjustment Indian Holding Co. Subscription of shares of Foreign Co. Outside India Foreign Wholly Owned Subsidiary • In the recent decision of Vijai Electricals Ltd vs. Addl. CIT [ITA No.842/Hyd/2012], tribunal held that investment made in subsidiaries abroad is not an international transaction u/s. 92B and TP provisions shall not apply as there is no income.

26. DEEMED INTERNATIONAL TRANSACTION Reasonable Approach? • TypicalFacts – Inbound Investment • Foreign parent company infuses share capital in the Indian subsidiary (at face value or at certain value per share arrived using DCF or other valuation methodology) • The Revenue takes a position that the shares have been issued to the Holding Company at an undervalued price / less that the fair market value of the shares; • The difference between the actual issue price and the ALP computed by the department is characterized as: • notional income of the Indian Subsidiary - treated as TP adjustment • loan by the Indian Subsidiary to its Holding Company - notional interest on such alleged loan treated as the TP adjustment Foreign Holding Co. Purchase / Subscription of shares of Indian Co. Outside India In India Indian Wholly Owned Subsidiary • The TP Officer made TP adjustment to the tune of Rs 15,200 Cr on the international transaction of receipt of Rs 870 Cr towards issue of fresh equity shares by Shell India stating that there was under-pricing in the issue of shares.

27. Emerging Areas of Controversies Selection of ‘Tested Party’

28. RECENT CONTROVERSIES - TESTED PARTY • Critical elements of a TP analysis, • Functions, Assets and Risk analysis (FAR analysis) and • Economic analysis, • The selection of tested party is the first step in any economic analysis and must find it’s “connect” back with the FAR analysis. The “connect” is the characterization of the transacting entities, which a FAR analysis must necessarily conclude with. • The characterization of the transacting entities is the critical determinant in deciding which entity would be the tested party. • While the concept of “tested party” does not find any mention in Indian regulations, the concept has been laid down in • The US Regulations, • OECD Guidelines • UN TP Manual

29. RECENT CONTROVERSIES – ‘TESTED PARTY’

30. Recent Controversies – Fundamental Issues Location Savings

31. Net location savings Other Location Specific Benefits Location Specific Advantages (“LSAs”) +/- = Recent Controversies - Location Saving • Location savings/ Location Specific Advantage/ Location rent & Market Premium • Who gets location rents ? • Multinationals generate enormous cost-savings by off-shoring • Often these savings end up in a tax haven or back in the home country • UN manual proposes an approach that would give developing countries a bite of the apple. • UN TP Model explains the Approach as under: +/- Location Rent (i.e. incremental profit) => Location Specific Advantages (“LSAs”) = Other Location Specific Benefits

32. Recent Controversies - Location Saving • Off-late, Indian authorities have made upward adjustments to the income of the Indian taxpayer by splitting the net location savings between the Indian taxpayer and overseas enterprise. • In many cases, the location savings are simply split equally between the Indian taxpayer and overseas enterprise assuming equal bargaining power. • In the recently released United Nations Transfer Pricing Manual for Developing Countries (India Chapter), the Indian authorities has advocated that, in the quantification and allocation of location savings amongst the parties, the profit split method (PSM) can be used wherein the functional analysis and bargaining power of the parties to the transaction would be relevant factors for consideration – benchmarking against local comparables does not take into account the benefit of location savings. • The Tribunal ruling in the case of GAP International Sourcing (I) Pvt. Ltd v. ACIT [2012] 25 taxmann.com 414 (Delhi), has not echoed the above views of the Indian authorities and held that: • “the intent of sourcing from low cost countries for a manufacturer/retailer is to survive in stiff competition by providing a lower cost to its end-customers. Generally, the advantage of location savings is passed onto the end-customer via a competitive sales strategy. The arm’s length principle requires benchmarking to be done with comparables in the jurisdiction of tested party and the location savings, if any, would be reflected in the profitability earned by comparables which are used for benchmarking the international transactions. Thus in our view, no separate / additional allocation is called for on account of location savings...” (emphasis supplied)

33. Emerging Areas of Controversies SPECIFIC ISSUES

34. Emerging Areas of Controversies Intra-Group Financing Transactions

35. Areas of focus by taxation authorities • No agreement in place; • Terms & Conditions lack economic substance; • Non exercise of prepayment or call options; • High debt/equity ratios; • Debt pricing resulting in low profitability; • Interest rates or credit margins; • Credit Guarantee Fees • Interest rates / guarantee fees that are arbitrary or based on a casual analysis, such as stray bank quotations;

36. CORPORATE GUARANTEE – Definition • Explanation to Section 92B(1) of Income Tax Act, 1961– • For the removal of doubts, it is hereby clarified that— • the expression "international transaction" shall include— • (c)  capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business; • What is a guarantee? • “A legally binding agreement under which the guarantor agrees to pay any or all of the amount due on a loan instrument in the event of non-payment by the borrower” • Whether extension of charge of existing securities with Indian bank for issuance of SBLC to its foreign branch on behalf of Indian company’s foreign AE be treated as guarantee?

37. CORPORATE GUARANTEE – Whether an International Transaction? • Corporate Guarantees under consideration are generally in either of following forms: • Corporate Guarantee is extended by Indian company on behalf of its foreign AE to the foreign branch of an Indian bank – Is it transaction between two Indian entities? • Corporate Guarantee is extended by Indian company on behalf of its foreign AE to the foreign bank or foreign branch of foreign bank • Corporate Guarantee is extended by Indian company to an Indian branch of Indian bank for issue of Stand-By Letter of Credit (‘SBLC’) or Letter of Comfort (‘LOC’) to its foreign branch on behalf of its Indian company’s foreign AE. • Benchmarking? • There is no transfer pricing regulation across the world which prescribes or defines a method for benchmarking guarantee fees. • The various approaches for benchmarking guarantee fees are: • CUP Approach • Risk of Loss Approach • Valuation of Benefit Approach/ Interest Saving Approach

38. Emerging Areas of Controversies ‘Marketing Intangibles (AMP)’

39. RECENT CONTROVERSIES – MARKETING INTANGIBLES • Issue/Controversy • Indian tax authorities have been identifying excessive Advertising, Marketing and Promotion (‘AMP’) expenses incurred by the Indian taxpayer by applying the bright-line test and applying a markup on such expenses to allege that the taxpayer was provide a service to the foreign brand owner, for which a compensation is due. • In case of LG Electronics India Pvt. Ltd. v. ACIT [2013] 29 taxmann.com 300 (Delhi)(SB),tribunal held that TP adjustments in relation to the AMP expenses incurred by the Indian taxpayer for creating and improving the marketing intangible for and on behalf of the foreign parent company is permissible. • Following the LG ruling, there have been series of other rulings on TP adjustment on account of AMP Expenses & marketing intangibles in the case of

40. RECENT CONTROVERSIES – MARKETING INTANGIBLES • Key Issues in the Special Bench Ruling in case of LG Electronics • The special bench has specified the following considerations which need to be applied to a taxpayers’ facts in determining whether any adjustment needs to be made: • Whether the foreign enterprise is compensating the Indian taxpayer for promotion of brand in any manner such as subsidy on goods sold to the taxpayer? • Whether the level of subsidy is commensurate with the brand promotion expenditure? • Whether the brand is at an entry level or at an established stage? • Whether there have been any new product launches or continuation of existing product range? • How the brand will be dealt with after termination of the agreement with the Indian taxpayer?

41. Marketing Intangible – Characterization of Distributor A Crucial Element

42. Emerging Areas of Controversies ‘Contract Research & Development’

43. Recent Controversies – Contract R&D • Circular 2 of 2013 - Circular on application of Profit Split Method • Methods such as Transactional Net Margin Method (‘TNMM’) evaluating value of intangibles on a Cost plus Return basis discouraged – no correlation between R&D cost and return on intangibles. • Preference for Profit Split Method (‘PSM’) - determines appropriate return on intangibles considering relative contribution by each AE. • Selection and application of PSM dependent upon factors prescribed under Rule 10C(2) • Onus on TPO to record reasons for non-applicability of PSM before considering other methods. In such cases, TPO empowered to consider TNMM or CUP. • Onus on taxpayer to have sufficient reason for non-applicability of PSM due to non-availability of information • Circular 3 of 2013 - Circular on conditions relevant to identify development centres engaged in contract R&D services with insignificant risk • Provides for 5 conditions to be satisfied cumulatively satisfied in order to treat a development centre in India as a contract R&D service provider: • Functions - economically significant functions are performed by AE • Funding - economic significant assets are provided by AEs. • Supervision & Control - direct control & supervision of the AE. • Risk Profile - significant risks are borne by the AE • Ownership Rights - rights of the intangible developed vests with the AE

44. Recent Controversies – Contract R&D • Recently, the Delhi Tribunal in the case of GE India Technology Centre Pvt. Ltd. v. DDIT [ITA Nos. 789/Bang/2010, 487 & 925/Bang/2011] made some interesting observations in relation to Contract R&D services, as under: • “Identification of risk and the party who bears such risks are important steps in comparability analysis. The conduct of the parties is key to determine whether the actual allocation of risks conforms to the contractual risk allocation. Allocation of risk depends upon the ability of the parties to the transaction to exercise control over risk. Core functions, key responsibilities, key decision making and level of individual responsibility for the key decisions are important factors to identify the party which has control over the risks.........The notion that risk can be controlled remotely by the parent company and that the Indian subsidiary engaged in core functions, such as carrying out research and development activities or providing services are risk free entities is something which needs to be demonstrated by the assessee.” • (Emphasis supplied) • The question as to “who exercises control” is a factual exercise i.e. the significant people functions and conduct of the parties involved must be necessarily substantiated and documented by taxpayers.

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